Capitalization: Concept, Theories & Fair Capitalization

One of the foundational responsibilities of corporate promoters and finance executives is determining the total long-term capital required by the enterprise. In corporate finance, this total long-term quantum is known as Capitalization.

1. Clarifying Terminology: Capital, Capitalization & Capital Structure

Students often confuse these three related terms in BBA exams. Here is their exact distinction:

1. Capital: The total actual wealth or economic assets employed in running the business (land, machinery, cash, inventories).
2. Capitalization: The total par value (book value) of long-term securities issued by the company. It represents the aggregate face value of:
   • Equity Shares
   • Preference Shares
   • Debentures / Long-term Bonds
   • Long-term Loans and Retained Reserves
3. Capital Structure: The proportionate ratio or composition of the different sources that make up capitalization (e.g., 60% Equity, 40% Debt).

Analogy: Capitalization is the total weight of the cake (e.g., 100 kg of long-term funds), while Capital Structure is the recipe or ingredients used (how many kg of flour, sugar, and butter).

2. Theories of Capitalization

How does a new business determine how much total capital it should issue? There are two primary theories:

A. The Cost Theory of Capitalization

Under the Cost Theory, capitalization is calculated by summing up the total initial costs required to acquire all fixed assets, cover preliminary launch expenses, and provide sufficient initial working capital.

Capitalization = Cost of Fixed Assets + Initial Working Capital + Preliminary Promotion Expenses

• Merits:
  • Very simple and objective to calculate for newly launched firms.
  • Useful for public utilities and capital-intensive infrastructure projects where initial asset expenditure is predictable.
• Demerits:
  • Ignores future earning capacity. A firm might spend ₹50 lakhs on high-end machines, but if consumer demand drops, those assets will fail to earn a fair return on that capital!
  • Creates distortions if assets are purchased at inflated prices during boom periods.

B. The Earnings Theory of Capitalization

Under the Earnings Theory, a company is worth what it can earn. Capitalization is determined by capitalizing the firm’s anticipated future net earnings at a normal rate of return expected in that specific industry.

Capitalized Value (Capitalization) = (Estimated Annual Net Earnings / Fair Normal Rate of Return) × 100

Numerical Example:

• A new manufacturing enterprise estimates it will earn an annual net operating profit of ₹3,00,000.
• In this manufacturing industry, similar companies normally yield a 10% return on capital employed.
• Fair Capitalization:

  Capitalization = (₹3,00,000 / 10) × 100 = ₹30,00,000

If the company issues ₹30,00,000 worth of securities, it will earn exactly 10%, which satisfies investors.

• Merits: Highly realistic, aligns share valuation with actual profitability, and forms the bedrock of modern equity valuation.
• Demerits: Very difficult for new startups to accurately forecast future sales and earnings in fluctuating economic conditions.

3. What is Fair (Normal) Capitalization?

A company is said to possess Fair Capitalization (or Normal Capitalization) when its actual earnings rate exactly matches the normal industry rate of return, and the book value of its shares equals their intrinsic real market value.

Conditions for Fair Capitalization:

1. Real Value of Assets = Book Value of Assets
2. Actual Rate of Earnings = Normal Rate of Return in the Industry
3. Market Price of Share = Face / Book Value of Share

In a fairly capitalized company:

• Shareholders receive fair and steady dividends.
• The company maintains healthy credit ratings and can easily raise fresh capital from banks.
• Customers and workers are paid fairly without pressure to cut corners.

4. Summary & Quick Revision Checklist

• Capitalization: Total face value of all long-term securities issued (shares, debentures, bonds, long-term debt).
• Cost Theory: Capitalization = Total initial cost of setting up the enterprise and buying assets.
• Earnings Theory: Capitalization = Estimated future earnings capitalized at the normal rate of return.
• Fair Capitalization: The ideal financial state where actual earnings match normal industry expectations and market value equals book value.